sign uplog in
Want to go ad-free? Find out how, here.

The combination of low unemployment and stubbornly low inflation across Western advanced economies has exposed the fundamental flaws of the standard economic theory that have long informed monetary policymaking. What theory should replace it?

The combination of low unemployment and stubbornly low inflation across Western advanced economies has exposed the fundamental flaws of the standard economic theory that have long informed monetary policymaking. What theory should replace it?

Former US Secretary of the Treasury Lawrence H. Summers and Anna Stansbury recently cast doubt on the future of central banking, suggesting that the prevailing monetary-policy framework is in dire need of a rethink. I agree, and have been calling for a reconsideration of “Old Keynesian economics” for more than a decade, starting with an article I published in 2006, two years before the Great Recession made it fashionable to question the way we think about macroeconomic theory. I am heartened that the narrative and body of research I have developed continues to gain public support.

In the current era of low – and in some cases negative – interest rates, many are starting to worry that the European Central Bank and the US Federal Reserve are “running out of ammunition.” When a central bank’s policy rate is already low, it cannot be lowered much more in the event of a crisis. Hence, one could argue that the Fed actually should be raising rates now, while unemployment is low, to create enough space for interest-rate cuts in the future, when unemployment may be high. Yet it makes no sense to raise interest rates if doing so could trigger a recession. The question, then, is whether there is a way to restock the powder keg without generating an explosion.

When the Fed or the ECB raises rates, New Keynesian economic theory predicts that the hike will eventually lead to a decrease in inflation, and that the path from point A to point B will inevitably be accompanied by higher unemployment. But my own research suggests that New Keynesian economic theory is wrong. After all, if the Fed were to raise the short-term rate slowly and support equity markets with a guarantee to purchase a broad-based exchange-traded fund at a fixed price, there is no reason why the rate increase should cause higher unemployment.

According to the theory, a lower interest rate is supposed to lead to more investment expenditure, thereby driving aggregate demand and reducing unemployment. And lower unemployment is supposed to put upward pressure on wages, which eventually translates into higher prices (inflation) through a mark-up mechanism. That is the point when the central bank reverses its policy and starts to raise interest rates. Yet this entire story is contingent on the assumption that there exists a unique natural rate of unemployment – that is, the “non-accelerating inflation rate of unemployment” (NAIRU) – at which the pace of price growth will neither rise nor fall.

Although New Keynesians acknowledge that the NAIRU may change over time, they cannot predict how it will behave. Rather, central bankers make internal calculations of the NAIRU, and these then feed into decisions about the policy rate. When the unemployment rate is below the current NAIRU estimate and inflation still fails to materialize, they simply conclude that the NAIRU must have fallen. This is not science; it is religion.

In my book Prosperity for All, I offer an alternative to this latter-day version of reading tea leaves. My theory recognizes that a non-accelerating inflation rate is consistent with any unemployment rate. This point was originally made by John Maynard Keynes himself, in The General Theory of Employment, Interest, and Money, and has been emphasized by post-Keynesian economists for decades. I have shown in my research that the post-Keynesian view can be reconciled with conventional microeconomic theory using a “new” theory of labor-market search.

The standard theoretical narrative is based entirely on the Phillips curve, which asserts a direct tradeoff between inflation and unemployment. This is the narrative that determines what research is allowed into the top economic journals, and which discussions take place in policy meetings at central banks around the world. It is the narrative that informs how everyone from journalists and academics to the wider public interpret monetary-policy decisions. But it is a misleading narrative, one from which we must escape if we are to improve how we manage modern market economies.

To that end, it is not enough to criticize the Phillips curve. If the theory is wrong, it must be replaced with something better, and by something other than a return to 1950s Keynesianism, as today’s critics of neoclassical macroeconomic theory seem to propose. According to Summers and Stansbury, government should “promote demand through fiscal policies and other means” (emphasis mine). While I agree that monetary policy will be impotent when Europe or the US enters another recession, I am not convinced that government spending is the right response. My own research provides empirical evidence that recessions are caused by crashes in asset markets. As such, it is better to stabilize asset prices than build bridges to nowhere.

Modern market-based societies have pulled more human beings out of abject poverty than any other known form of economic organization. But “capitalism” is not some monolithic structure that exists in contradiction to “socialism.” There is a continuum of alternative economic arrangements, with laissez-faire at one end and central planning at the other. Our goal should be to design institutions that take maximum advantage of the market as a mechanism for coordinating information, while also providing the tracks on which the market runs.

Roger E.A. Farmer is Professor of Economics at the University of Warwick, Research Director at the National Institute of Economic and Social Research, and author of Prosperity for All: How to Prevent Financial Crises. This content is © Project Syndicate, 2019, and is here with permission.

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.


He so nails the flaw in economics.

Then reinforces it by failing completely to address depletion, degradation etc.

You can't have prosperity for all, with an unlimited population. I haven't read his book (yet) but it smells like it will be missing in action too. And look at his title. Sigh.

Couple of big assumptions there PDK. I think he is just trying to forment a change in thinking, challenging the "conventional wisdom", and incremental change is far easier to achieve than transformational change. As we so often acknowledge, Governments, and bureaucrats are too often bound by rigid frameworks based on so called "expert" advice. and all too often it is exceedingly difficult to change those frameworks, even when the flaws in the advice that framed them are fairly obvious. Economists absolutely must be recognising by now the impacts of unrestrained growth (in all areas) on the planet by now, or else their head is buried so far in the sand they wouldn't be able to tell day from night. So assuming he is referring to unlimited population is probably a little unfair, unless of course he specifically states it.

Worry not...we shall simply 'innovate' the problem away (contrary to that real science, physics)

Surely the flaw is in the conceptual framework that manipulating prices by central planning is a solution. Isn't this what destroyed the USSR? The success of civilised capitalist societies has surely been due to the freedom of individuals to find alternative solutions to the problems that affect them, both individually and collectively. Adapability and evolution, not control and manipulation.

To me, falling interest rates suggests falling opportunity. So the question that should be asked is why is this? Excess productive capacity? Excess regulation? Actors gaming the system? Excess foreign capital inflow? Why, why, why?

lack of opportunity is the why in itself. Everything else is flow-on.

The USSR was a less adaptive system to draw down resources, but both systems draw down resources and it was only a matter of time before the capitalist one ran into the Limits to Growth wall too.

I agree PDK. Roger the capitalist system was supposed to be for everyone, but the introduction of Friedman's free market theory enabled the big players to monopolise the markets, and this is where they stifled opportunity. The big players either forced competition out of the market or just bought them out. It developed from there.

The why is simply greed

the theory is flawed due to a certain small number of individuals owning the vast majority of profitable companies across the globe.

The supply chain they have their hooks in is so vast they are collecting so much super profits that there is nothing any Central bank can do to replenish the system.

NZ's largest exporter for example would need to make a profit of $500 million for 40 years, to make just one year of foreign Owner profits, $20 Billion per annum.

Business dictates they need a continual 10-15% return on Investment, which is growing at such a phenomenal rate due to the profits they are generating.

Now we're at the Hockey Stick end, where 95% of the world, and NZ, live off the tiny end of the stick, while the Handle of the Hockey Stick represents the FOreign Owned profits of a very few individuals.

They know who they are, and what they are doing to humanity.

World War 1 and II were a waste of time as there is now no freedom/democracy pot of gold for our grandparents who died for their country to be free of this type of Tyranny.

Banks are the worst offenders.

Take NZ, a foreign bank has just appointed as its Board Chair an ex NZ Prime Minister.

Said bank is making $2 Billion profit on its own. We don't even have a Trade Surplus of this amount.

A strategic appointment no doubt by the elite Banking cartel.

I wish the Central banks all the best in their endeavours to rectify this rort. But sadly the ideology, lobbying and false narrative will prevent them ever fixing the problem.

Agreed. It has been like playing Monopoly on the Titanic - the winners have gotten winnier and the losers have gotten losier, but the whole shebang was presuming of ongoing supply of real stuff. That presumption still includes the word 'growth' in front of 'supply', too.

The Banking System has become somewhat parasitic. In response, central banks carefully modulate our interest rates, so they don't kill the hosts (us). The situation here is not dire, yet, a few simple fixes would change the trend. Or we can continue to follow the example of Argentina.

While foreign investment usually benefits developing economies and creates local economic benefits in advanced economies, it generally does not benefit advanced economies on the whole except in very limited cases. On the contrary, foreign investment in advanced economies is more likely to lead to higher unemployment or rising debt.

Taxing capital inflows is a far better way to balance trade than imposing tariffs. This would address the root causes of trade imbalances, improve the productive investment process, and shift most of the adjustment costs onto banks and speculators.

You almost nailed it.

With the level of foreign investment now has, NZ now require to tax exported profits more heavily.

Foreign investment just mopped up some 13% of the Port of Napier, when their was sufficient demand from local investment to take this. It happens because the merchant banks are subsidiaries of the overseas establishment.

Key sold the same lie when selling our energy companies. The pattern is pretty obvious I would have thought, and its time the NZ government started working for its people, rather than these overseas used car salesmen.

With hindsight, John Key's job was to sell us out to the usual foreign suspects. Uber instead of Kiwi profit taxis. McD and KFC and Dominoes instead of local fish and chips. Foreign banks etc, etc, etc. And he, and his crony capitalist mates have not finished with us yet.

My favourite alt definition of an Economist....'One who observes something working in Practice (on the ground) and goes on to find out whether it will work in Theory also (in the cloud)'.

Economists have never been reliable with forecasts.

Why they keep teaching about free market in schools and universities, when the opposite is closer to the truth.

The conclusions you and I can only draw from this is they are used as smoke screens, to detract the masses from the reality.

Until the supply of money is tied to the gold standard, economics is a lie. Follow the money, and you'll discover the truth behind the world's biggest Ponzi scheme.

Economics was always a false truth, manipulated by those with the means, for power and control over others. Prior to economics was the church, before them kings and queens and their militia. Everything now is merely an extension of everything prior.

Economic theory was based on assumptions of human nature/behaviour, influenced by the writer's own unconscious bias, without questioning the influence of conditions, environmental and societal constructs at the time. Unfortunately the ignorant, powerless masses are at the mercy of the "ruling" classes and that can/will only change when the masses realise they have the numbers. Unfortunately the divide and conquer mechanism is working too well. If you're not writing the rules you're not part of the ruling class.

We have created a false concept of wealth and poverty, of value, and become so attached to these concepts it's impossible for us to question them let alone see outside these constructs. Monetisation of everything is an underlying cause.

Science is now suggesting what ancient esoteric teachings already taught. Human nature can be altered and is not stuck in biology. The environment and societal conditioning is the main nurturing influence

What's the solution going forward? A lot of unlearning and relearning. Ideally ethical standards and a collective vision wider than the current human ego centred model. Economics must become a function of a unified vision that everyone can contribute to rather than life being a function of economics.

What is the market? It's humans. What do people really demand, not what they've been taught and manipulated to demand. Corporations have too much influence and power. They do not exist to serve the people and this needs to change.

Why don't we spend more time talking about improving productivity instead of creating more debt?

Because their days are nearly over. Labour represents less than 1% of the work done globally, so productivity gains were really energy efficiencies of the other 99%. And energy efficiencies all have limits - Carnot and the Second Law prevail.

Folk like me have for decades reckoned they'd plateau, to the amazement of the economics brigade it turns out.

But there IS INFLATION. Wherever that new cheap money has been allocated you've seen STUPENDOUS inflation.

Who are the most over rated ? And who is the most dangerous ?
Economists, Rating agencies or Central Banks ?